How Goldman Sachs Screwed Up A $580 Million Acquisition

Loren Feldman, an editor of Small Business at New York Times Digital, wrote a great article in The New York Times about how Janet and Jim Baker are fighting Goldman Sachs over a deal that went wrong in 2000. Back in 2000, the board of directors approved a sale of Dragon Systems for the price of $580 million. The investment bankers at the acquiring company Lernout & Hauspie sent a bottle to the CEO of Dragon to congratulate them, but they did not hear from their own banker Goldman Sachs.

“I still have not received anything from Goldman,” said the Dragon Systems CEO in an e-mail to L&H’s bank. “Do they know something I should know?” Dragon’s founders are still battling Goldman to find out what happened. James and Janet Baker spent almost 20 years building Dragon, which is a voice technology company that was making multi-million dollars. In late 1999, the offers for the company started to come in for the company.

The acquisition of Dragon was supposed to be all-stock, but Goldman collected millions in fees. The Bakers lost it all when L&H turned out to be a fraud. L&H was founded by Pol Hauspie and Jo Lernout. Goldman themselves almost considered investing in L&H, but walked away after learning more about the company. The Bakers are seeking $1 billion from Goldman as part of interest, legal fees, and damages. The amount is about twice what Goldman paid to settle claims related to subprime mortgage investments.

The Bakers are currently in the 60s and both studied for Ph.D’s. They became interested in voice-recognition technology in the 1970s. James believed came up with the idea of working on voice recognition when he found out that voice recognition could be reduced to math. You just needed to calculate the mathematical probability of one sound following another. This idea became an industry standard.

The Bakers started Dragon Systems in 1982 and refused to take in any venture capital. They financed their own growth with their revenues. Once they had a product, they figured that the company could last at least 18-24 months. Their first product was created for a British PC called the Apricot. They followed that up with DragonDictate, which was a speech-to-text system. After the company started gaining traction, Janet Baker negotiated a deal with Seagate. Seagate bought 25% of Dragon Systems for $20 million.

In 1997, Dragon Systems launched a product called Dragon NaturallySpeaking. This product recognized more words than what could be found in a dictionary and it worked in 6 languages. Two years later companies like Intel and Sony expressed interest in buying the company. Another offer was made by Ford Motor subsidiary Visteon. The most appealing offer came from L&H.

Goldman Sachs was associated with extreme professionalism and was one of the smartest investment banks on Wall Street. This was the primary reason for why Dragon decided to work with them. At that time Goldman was being run by Henry Paulson Jr., who became the Treasury Secretary and was in charge of the Wall Street bailouts. Goldman assigned four bankers to the Dragon Systems account. At the time Dragon Systems had 400 employees and was making $70 million in revenues. Dragon agreed to pay $5 million as part of a flat fee.

Before the engagement letter was signed, Goldman sent them a memo indicating that they would explore specific areas of concern at L&H including the company’s sources of revenues, major customers, license agreements, and royalty agreements. They would also explore L&H’s growth, partnerships, and financial statements. Richard Wayner, one of the Goldman bankers, went with Janet Baker and Dragon’s CFO Ellen Chamberlain to visit L&H executives to conduct merger analysis. They looked at the earnings per share and total debt under three acquisition types: all cash, all stock, and half-half.

Initially L&H proposed $580 million, half in cash and half in stock. The Bakers were not sure and news reports were questioning L&H’s revenues. Baker felt that L&H’s voice recognition technology was inferior. In mid-February 2000, Chamberlain sent an angry memo to Goldman. They urged Goldman to move faster in preparing analysis around L&H. Talks with other companies were going no where so she wanted Goldman to drive the due diligence. Supposedly Goldman sent Dragon a memo asserting that Dragon’s accounting company Arthur Anderson should be doing the work. The Goldman employees are uncertain who sent Dragon that memo. The memo was not brought up again until the lawsuits were filed.

The Dragon execs thought that Goldman would be analyzing L&H. Dragon paid Goldman $5 million for advice and for due diligence. But if Goldman was not conducting the due diligence, it was uncertain what Dragon was paying for.

“They put items on and off the due diligence list,” said Janet Baker. “We discussed the issues at — at basically every meeting that we were at, and we were meeting often in person or by phone, typically, several times a week in this time frame — sometimes multiple times a day, as we’ve seen. And so they knew what everybody was doing. And they were, they were directing it.”

One of the biggest concerns was L&H’s wildly fluctuating stock price. Richard Wayner, one of the Goldman bankers, set up a conference call with Goldman bankers in London. Wayner told Janet Baker that Charles Elliot, a Goldman analyst in London was following L&H’s stock and was up to date on the fluctuations. Elliot assured Janet that investors were worried about the market in general rather than L&H in particular. He said that expected L&H’s stock to go up after a merger was struck.

Elliot admitted later that he was not tracking L&H. He said that responsibility was left for another Goldman analyst that let the company shortly after the Bakers started working with Goldman. L&H’s coverage was terminated by Goldman after the other analyst left. But no one had told the Bakers that they stopped covering L&H. Elliott also had no idea that L&H was claiming huge revenues in Asia. If Elliott had known about the revenue gains, he would have indicated that they would be very skeptical about the gains.

Two weeks after an agreement was made, Wayner told Janet that he would be leaving for a vacation and would not be participating in a conference call with L&H’s accounting company KPMG. Wayner was still on vacation on March 27th when Dragon’s board of directors met to take a final vote on the acquisition. Goldman did not give a presentation, but minutes before the meeting, Goldman bankers indicated that Dragon and L&H would create a market leader. The board decided to unanimously to accept the $580 million all-stock deal.

The deal was closed on June 7th and by August 8th, the merged companies hit a crisis. It turns out that L&H’s books were fraudulent. The Wall Street Journal called L&H’s supposed customers in Asia and reported it in the news. Goldman employees did call the supposed Asia customers, but never reported it to the Bakers. It turns out that L&H completely made up their sales figures.

Goldman decided against investing $30 million into L&H. Around the end of November, L&H went bankrupt. L&H’s stock hit $0 and the Bakers lost everything. Dragon went for sale at a bankruptcy auction. Visteon bought some of Dragon’s technology and so did ScanSoft. ScanSoft did a licensing deal with Apple and the Bakers believed that some of their technology ended up in Siri. ScanSoft was renamed Nuance before getting acquired.

Goldman Sachs released a defense statement saying: “Goldman Sachs was retained as a financial adviser by Dragon Systems, not its shareholders, and performed its assignment satisfactorily in all respects.” Goldman’s lawyer said that only Dragon Systems had the right to sue, but Dragon no longer exists. Goldman even filed a counter-lawsuit.